Purchase Consideration

In consolidation, purchase consideration is the cash or stock, or other assets transferred by the acquirer to the acquiree or its shareholders in return of the acquiree’s assets or its stock.

When one company acquires another, it must pay a consideration which may be in the form of cash it pays to the acquiree or its own common stock. In a statutory merger, a business combination in which the acquiree dissolves and its assets combine with the continuing company, the purchase consideration is paid to the acquiree’s which distributes it to its shareholders during dissolution. In case of a statutory consolidation, a business combination in which the acquiree continues a legal entity, the purchase consideration is paid to the shareholders of the acquiree.

The consideration is either predetermined in terms of its value or its contingent. Contingent consideration is the portion of purchase consideration whose payment and/or magnitude is dependent on some future parameter.

Purchase consideration is an important number in finding out if any goodwill arises during a business combination through the process of purchase price allocation. If the fair value of the purchase consideration is higher than the fair value of the net assets of the acquiree, the difference is attributable to goodwill. Alternatively, if the fair value of purchase consideration is lower than the sum of fair values of individual net assets of the acquiree, it is a bargain purchase which results in a gain for the acquirer in the year of acquisition.

Example

Company A acquires Company B for $50 million in cash and a share of common stock of Company A issued for each share of the Company B’s common stock. Total number of shares of common stock outstanding for Company B are 10 million. Further, the acquisition understanding requires Company B to pay $1 million per $2 million of net income generated in excess of the earnings target for Company B during next 3 years. The present value of such expected payment is $15 million. Find out the value of purchase consideration if current stock price of Company A is $45 and current stock price of Company B is $25.

Purchase consideration in this scenario has two components: the fixed component which is transferred right at the acquisition date and a contingent component which is payable in future.

The fixed consideration is valued at the fair value of consideration transferred. It amounts to $95 million (i.e. cash of $50 million plus fair value of Company A’s stock issued of $45 million (=$45 × 1 million).

The contingent consideration is valued at the present value of expected outflow in future. In this particular case, it must be recognized as a liability because the value is not determined in terms of number of shares of common stock of Company A. It amounts to $15 million.

Total purchase consideration is hence $110 million (i.e. fixed component of $95 million plus contingent consideration of $15 million).

Written by Obaidullah Jan, ACA, CFA and last modified on